as the yardstick, the best, average, and worst brokers were capable of only 83 percent, 75.6 percent, and 61 percent of the return gener- ated by 100 percent stocks (Score 2 in Table 2.2). Score 4 in the final column in Table 2.2 shows how well a $10,000 initial investment would have faired with each portfolio. The best, average, and worst broker portfolios achieved only 76 percent, 68.9 percent, and 55 per- cent of the 100 percent stocks result after 10 years.
Brokers will no doubt squeal about the lower volatility of their portfolios compared to the optimal or pure stock portfolios. But for investors who lock up their money in a retirement account and cannot touch it anyway, what does volatility matter? We will discuss the trade- off between return and volatility and how they are measured in later chapters, but the fluctuations mean nothing to long-term investors.
What counts for them is the ending value of the portfolio when they need it—for retirement, their kids’ college expenses, or whatever.
The bottom line is that those who claim to be advocates of asset allocation appear to have missed the primary conclusions of the original BHB research. They continue to try to time the market and pick the best stocks, but they now do it in the context of asset allo- cation. The problem is compounded by recommendations to rebal- ance every quarter or every year to match whatever formula they currently recommend. Procrustes must be chuckling in his grave.
Cynics might suggest that it is the brokerage companies’ own bottom line that they are most concerned about rather than their clients’ bottom line. In fact, Arthur Levitt’s book, mentioned earlier, is a stinging commentary on the investment industry.9 As an insider, Levitt saw abuses and corrupt practices that harmed investors by taking advantage of their ignorance and trust. The pervasiveness of this so appalled his sense of decency that he felt compelled to write the book, and will probably be a marked man in the financial community forever. Most whistle-blowers are. The recent and continuing scandals concerning trading violations by major players and mutual funds in the industry suggest that Levitt and the other cynics are right.10
1. It forces investors to think in terms of the big picture for their investments by making them aware of the various types of asset classes that they can use to meet their investment goals.
2. It explicitly recognizes the differences and trade-offs among the various types of asset classes in terms of risk and return and the inherent volatility of the market.
3. It promotes diversification of investments, so that the investor’s eggs are in different baskets. Diversification is one of the cornerstones of modern portfolio theory.
Likewise, this critique of asset allocation is not intended to sug- gest that all financial advisers who utilize asset allocation are acting in bad faith. By asking deep questions about a person’s life goals, assembling facts and figures, and guiding funds into the right sorts of accounts to take advantage of tax laws, many advisers provide valuable service to their clients. The reason they attempt to fit their client’s needs into the formula-based asset allocation model is because it is the only model available from their research departments. There is no other choice. It operates as a conceptual monopoly.
This is the real problem: Asset allocation has been oversold. It commits a “one-size-fits-all” fallacy. Honest, hard-working financial planners, looking for help from their research departments, theo- reticians, and academics to deal with the hopes and fears of their clients, have been led to believe that asset allocation is the panacea for all investors. It is treated as if it were the only honest game in town to justify and add value to the services they provide to their clients. Unfortunately, as the old saying goes, when the only tool you have is a hammer, every problem becomes a nail.
In the next chapter, we will look at a new tool, asset dedica- tion. It addresses a number of the gaps in asset allocation. One of its primary advantages is the fact that it truly customizes a portfo- lio for each person instead of trying to force-fit that person into an arbitrary category.
NOTES
1. Gary P. Brinson, in Robert G. Ibbotson and Gary P. Brinson, Global Investing: The Professional’s Guide to the World Capital Markets (New York: McGraw-Hill, 1992), p. 58.
2. The arithmetic average that most people know is what statisticians call the mean (the number calculated by adding a list of numbers and dividing by how many numbers are on the list). Chapter 12 will cover statistical concepts in greater detail.
Asset Allocation: The Gaps 31
3. The tables of probabilities found in any statistical textbook show that the probabil- ity of getting 10 heads in 10 flips of a fair coin is .001, or 1 in 1000. With over 10,000 mutual funds, it could be expected that, even if the probability of success in any one year is only 50 percent, there will at any one time be 10 fund managers who can point to successful market calls over the past 10 years.
4. A web site that will calculate the expected returns for 20 different asset allocations ranging from 5 to 100 percent stocks can be found at http://www.ifa.tv.
5. The group that runs www.personalfund.com offers a number of articles and tools on evaluating mutual funds. The recent scandals involving malfeasance on the part of mutual fund managers suggest that these managers’ subpar performance may be due to more than simply an inability to forecast the market.
6. Dorfman initiated the project and ran it for 9 years before leaving the Journalin 1997. Other journalists continued the articles until 2000, when they disappeared from the paper. Compiling and maintaining the statistics required a significant amount of effort, and perhaps no one else has the perseverance to continue the study. After he left the Journal, Dorfman became a money manager and now runs his own investment company (www.dorfmaninvestments.com).
7. The allocations shown are for the 40 quarters from Q3 1990, through Q2 2000.
Although the study actually began in 1988, mergers of brokerage companies and missing data prevented a complete tally of all 48 quarters. Estimates from the com- plete series of 48 quarters are not significantly different from the results shown here.
8. Results for two of the brokers, Goldman Sachs and Raymond James, had to be adjusted slightly because a few data points were missing and had to be estimated by extrapolation or interpolation.
9. Arthur Levitt, Take on the Street(New York: Pantheon, 2002). Levitt was chair of the Securities and Exchange Commission (SEC) from 1993 to 2000.
10. Allan Sloan, “Cleaning Up a Dirty Business,” Newsweek,Oct. 13, 2003, p. 49.